The battle over bonds

INTEREST ON municipal bonds has been tax-free since the federal income tax began in 1913. As a result, "muni" bond issuers could offer relatively low interest rates and still attract flocks of investors, enabling state and local governments across the country to build schools, roads and waterworks more cheaply than they would have if the interest were taxable. Yet in recent years economists have argued that much of the forgone federal tax revenue accrues as a windfall to investors in the highest tax brackets. It would be fairer and more efficient, they argue, to let state and local governments sell taxable bonds with higher interest rates and to have Washington reimburse them directly for a percentage of their interest expense.

For almost two years, the Obama administration has been doing just that. The 2009 stimulus bill created a taxable financial instrument - Build America bonds - that state and local governments may use to finance infrastructure. The federal government pays 35 percent of the interest. So far, the bonds have proved popular: Issuers have sold some $158 billion worth, including many to foreign investors, pension funds and other untaxed entities that had no reason to buy tax-exempt munis. Indeed, the Build America bonds have displaced tax-exempt munis to a significant degree, especially in the longer maturities. The program has funded everything from a bridge across the San Francisco Bay to mass transit in New Jersey.

But it expires Dec. 31. The lame-duck Congress has to decide whether to extend it, despite the fact that it began as a short-term emergency measure. The Obama administration has proposed making the program permanent, while allowing nonprofit organizations as well as state and local governments to participate - and reducing the subsidy rate from 35 percent to 28 percent. Many Republicans look askance at the idea, suggesting that it would essentially entrench yet another costly federal benefit that enables states to live beyond their means.

The critics have a point: Outlays for Build America bond subsidies exceeded projections, and the government may have recouped less revenue than expected because non-tax-paying entities bought so many of the bonds. However, the administration addresses these concerns by reducing the subsidy to 28 percent, which it says would be revenue-neutral. The administration could hold the costs down further by eliminating its plan to let nonprofits participate. To be sure, the lower subsidy would also make the bonds a harder sell for issuers, and there is always the risk that issuers would lobby for a bigger subsidy once the program is permanent.

But federal subsidies for municipal bonds, via the tax code, are already a permanent part of the financial landscape. The real-world choice here is not between a big subsidy and none at all. It is between administering the subsidy with or without a windfall to upper-income taxpayers. An appropriately revised Build America bonds program could make federal support for state and local infrastructure spending more efficient, and that is what Congress should enact.